A Welfare Analysis of Tax Structures with Love-of-variety Preferences

Abstract

This paper reassesses the general trade-off between ad valorem and specific taxation
using an economic model that features love-of-variety preferences and encompasses a
wide range of market conduct – including both quantity and price competition – while
allowing for firm entry and exit. We derive formulas for efficiency and incidence of
both types of taxes that depend on the responsiveness of product variety to taxes and
the effect of a change in product variety on consumer surplus. We use our formulas to
derive a desirability condition for when ad valorem taxes are more efficient than specific
taxes and a condition for when ad valorem taxes lead to greater pass-through than
specific taxes. We identify and estimate the model parameters using a quasi-experimental
“county border pair” research design that uses state-level and county-level variation in
sales taxes combined with detailed scanner data covering grocery stores in the U.S. Our
empirical results indicate that sales taxes are slightly overshifted onto consumer prices,
have a large effect on quantity demanded, and have a more modest effect on the variety of
products available to consumers. Using the estimated parameters, we recover consumers’
love-of-variety, infer whether or not product variety is socially optimal (at current tax
rates), and implement our desirability condition. We find that specific taxes are more
efficient at the margin than ad valorem taxes given the estimated love-of-variety. This
suggests that policymakers should consider using specific taxes and tariffs in markets
with substantial product differentiation.

Keywords: ad valorem taxes, specific taxes, pass-through, love-of-variety preferences

JEL Classification: H21, H22